Question

Suppose today you are considering whether to buy Stock Theta, and you want to do some basic analysis before buying the shares. By reading the firm’s most recent Balance Sheet, you find the following information: Net Income is $5,000,000, Total Shareholders’ Equity is $25,000,000, Total Assets is $40,000,000. From other publicly available sources, you further obtain the following information: the most recent earnings per share (EPS) is $3, the dividend payout ratio is 60%, and the firm’s beta is 1.4. The firm’s shareholders just receive the most recent dividends based on the above EPS and payout ratio today. Assume that the risk-free rate is 4%, and the market portfolio return is 16%.

Please answer the following questions:

(Please show your intermediate processes, instead of just a final number for your answers. Only round your final answers to two decimal places.)

(a) what is the return on equity (ROE) and dividends per share for this firm today?

(b) suppose this firm has a constant sustainable growth rate, what is the value of it?

(c) according to CAPM, what is the required rate of return you would expect based on the firm’s beta?

(d) based on the constant growth model and all your calculated results above, what would be the intrinsic value of this stock today? Assume that the dividends will increase at a rate of what you obtained from (b).

(e) Today, if this firm decides to pay out all its earnings as dividends forever and there is no any change in the amount of dividends, what would be the corresponding intrinsic value of this stock? Based on your calculation and results from (d), what would be the present value of growth opportunities (PVGO) for this stock?

Answer 1

ANS- A) ROE= 20% , Dividend per share = 1.80

- ROE = Net income / total share holder equity , Dividend per share = EPS * dividend payout ratio.

- ROE = 5,000,000 / 25,000,000 = 0.200 or 20% , Dividend per share= 3 * 0.60 = 1.80.

B) Sustainable growth = 8%

- Constant sustainable growth = ROE * Retention ratio , Retention ratio= 1 - dividend payout ratio.

- Retention ratio = 1- 0.60 = 0.40.

- Constant sustainable growth = 0.20*0.40= 0.08 or 8%.

C) Required rate of return = 20.80%

- Required rate of return using CAPM = Risk free rate(Rf) + beta *( market return - Rf).

- Required rate of return = 0.04 + 1.4*(0.16 - 0.04) = 0.2080 or 20.80% .

D) Intrinsic value of stock = 15.18

- For constant growth model, we will use Gordon growth model to find intrinsic value of stock-: = Dividend per share *(1+growth) / (rate of return - growth).

- Intrinsic value of stock = 1.80 *(1+0.08) / (0.2080 - 0.08) = 15.18